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F1 1
ACCOUNTING AND
ORGANIZATIONS
What do we need to know to start a business?

I n December of 2003, Maria and Stan were very excited about starting a company to
sell cookies made using their mother™s recipes. To honor their mother, they decided
to call the business Mom™s Cookie Company. Realizing they did not have much money
and had little business experience, the brother and sister made plans to start with a small
company. They hope the business will grow as more customers become aware of their prod-
ucts. Maria and Stan know that accountants provide advice to help managers of companies
better understand their businesses. Because they had never started a company before, they made
an appointment with Ellen Coleman, an accountant who had provided helpful business advice to
several of their friends.


FOOD FOR THOUGHT
Suppose you were in Maria and Stan™s position. What would you want to know in order to start a
business? What goals would you have for the business, and how would you plan to reach those goals?
What resources would you need in your business, and how would you finance those resources? How
would you organize your company? Who would your customers be? How would you know whether you
are reaching your goals or not? These are issues Ellen poses to Maria and Stan.


Creating a successful business is not an easy task. You need a good product, and you need a plan to
Ellen:
produce and sell that product.
Stan and I think we have an excellent product. We don™t have a lot of money for equipment and other
Maria:
resources, but we have identified a bakery that could produce our products using our recipes and
according to our specifications.
Also, we have spoken with several local grocery chains that have been impressed with samples and have
Stan:
agreed to sell our products.
Good. A primary goal of every successful business is to create value for customers. If you focus on
Ellen:
delivering a product that customers want at a price they are willing to pay, you are also likely to create
value for yourselves as owners of the company. You have to make sure you know what it will cost to run
your company and decide how you will obtain the money you need to get started.
We have some money in savings, and we plan to obtain a loan from a local bank. Those financial
Stan:
resources should permit us to rent a small office and purchase equipment we need to manage the
company. Also, we will need to acquire a truck for picking up the cookies from the bakery and delivering
them to the grocery stores.
You will need a system for measuring your costs and the amounts you sell. That system is critical for
Ellen:
helping you determine whether you are accomplishing your goals.
Stan and I don™t know much about accounting. Can you help us get started?
Maria:
I™ll be happy to help you. First, let™s explore in more detail some of the issues you need to consider.
Ellen:
F3
CHAPTER F1: Accounting and Organizations
2 Accounting and Organizations



OBJECTIVES

Once you have completed this chapter, you 5 Identify business ownership structures and
should be able to: their advantages and disadvantages.
1 Identify how accounting information helps 6 Identify uses of accounting information for
decision makers. making decisions about corporations.
2 Compare major types of organizations and 7 Explain the purpose and importance of
explain their purpose. accounting regulations.
3 Describe how businesses create value. 8 Explain why ethics are important for
business and accounting.
4 Explain how accounting helps investors
and other decision makers understand
businesses.



INFORMATION DECISIONS
FOR
All of us use information to help us make decisions. Information includes facts, ideas,
OBJECTIVE 1
and concepts that help us understand the world. To use information, we must be able
Identify how accounting to interpret it and understand its limitations. Poor information or the improper use of
information helps information often leads to poor decisions.
decision makers. As an example, assume you wish to drive from Sevierville to Waynesville. The drive
will take several hours and require several turns on unfamiliar secondary roads. There-
fore, you use a map, as illustrated in Exhibit 1, to provide information to help guide
you along the way.


Exhibit 1
Waynesville
Map from Sevierville to
Waynesville
441
15




12
17


446


11


Townsend

Sevierville
15



Binfield
Nough




Why is the map useful? The map can help you plan your trip. You have selected a
primary goal: arrive at Waynesville. You may have other goals as well, such as getting
there as quickly as possible. Or perhaps you wish to stop at various points along the
way. The map provides information about alternative routes so that you can select the
F4 SECTION F1: The Accounting Information System
3
Accounting and Organizations

one that is shortest, fastest, or most scenic. Using the map along the way helps you
make decisions about where to turn or stop. It helps you determine how far you have
traveled and how much farther you have left to go. It helps you decide whether you are
on the right road or where you made a wrong turn. It helps you decide where you are,
how you got there, and where you are going.
Accounting provides information to help in making decisions about organizations.
This information is like a map of an organization. Accounting information helps de-
cision makers determine where they are, where they have been, and where they are
going. Rather than measuring distances in miles or kilometers, accounting measures an
organization™s activities by the dollar amounts associated with these activities. The pri-
INTERNATIONAL
mary measurement unit for accounting information is dollars in the United States or
the local currency for other countries.
Maria and Stan have decided to start a business selling cookies. Their company will
pay a bakery to produce the cookies and will sell the cookies to local grocery stores. An
early decision they have to make is to identify the resources they will need to start and
run their business. They will need merchandise (cookies) to sell and will purchase those
products from a supplier (the bakery). They will need a place to operate the business
and someone to pick up the products and deliver them to sellers (grocery stores). They
will need money to pay for the merchandise, rent for their office, wages, equipment,
and miscellaneous costs such as supplies and utilities.
As an initial step in deciding whether to start the business, Maria and Stan might
consider how much they expect to sell. Suppose that after discussing this issue with gro-
cery store owners, they determine that the company will sell about $12,000 of mer-
chandise each month.
Next, they consider how much money they will need to operate their business. A
discussion with the bakery indicates the cost of the merchandise will be $8,000 each
month. After consideration of their other needs, they calculate their monthly costs
will be:

Merchandise $ 8,000
Wages 1,000
Rent 600
Supplies 300
Utilities 200
Total $10,100

From this information, they decide they should expect to earn a profit of $1,900
($12,000 “ $10,100) each month as shown in Exhibit 2. Profit is the amount left over
after the cost of doing business is subtracted from sales.


Costs of Resources Used
Exhibit 2 Sales
Expected Monthly
Earnings for Mom™s
Sales of merchandise $12,000 $ 8,000
Merchandise sold
Cookie Company
1,000
Wages
600
Rent
300
Supplies
200
Utilities
$10,100
Total




Profit $1,900
F5
CHAPTER F1: Accounting and Organizations
4 Accounting and Organizations

Does this appear to be a good business for Maria and Stan? Suppose they each have
$5,000 to invest in the business. They will use this money to purchase merchandise and
to pay for rent, wages, and the miscellaneous costs for the first month. Would invest-
ing their money in the business be a good idea?
If they don™t invest in the business, they could earn interest of about $50 a month
on their $10,000 of combined savings. The expected profit of $1,900 is considerably
larger. However, they also should consider the wages they could earn if they worked
for someone else instead of working in their own company. Additionally, they should
consider how certain they are about the amount they can earn from their business and
how much risk they are willing to take. Investing in a business is always risky. Risk is
uncertainty about an outcome, such as the amount of profit a business will earn. If the
company sells less than Maria and Stan expect, its earnings also will be less than ex-
pected. If the company does not do well, they could lose their investments. Are they
willing to take that risk? Accounting can help with these decisions by providing in-
formation about the results that owners and other decision makers should expect will
occur. Decision makers then have to evaluate that information and make their decisions.
Accounting is a way of looking at a business. It measures the activities of a busi-
ness by the dollars it receives and spends. It helps decision makers determine where
they started and where they should end up. It helps determine whether expectations are
being met. In the case of Mom™s Cookie Company, accounting identifies the company™s
starting point by the $10,000 Maria and Stan invest in their business. It identifies an
expected ending point as the amount of profit of $1,900 they expect to earn each month.
It provides a means of determining whether expectations are being met by measuring
business activities each month to determine whether the company is actually earning
$1,900 each month. Like a map, accounting can help decision makers determine that
they are not where they want to be. It can help them determine what went wrong and
what they might do to get back on the proper route.
Accounting provides a model of a business by measuring the business activities in
dollar amounts. Underlying this model is an information system. This system provides
a process for obtaining facts that can be converted into useful information. Under-
standing the system and its processes will help you understand the information pro-
vided by accounting.
The purpose of accounting is to help people make decisions about economic ac-
tivities. Economic activities involve the allocation of scarce resources. People allocate
scarce resources any time they exchange money, goods, or services. These activities are
so common that almost every person in our society uses the accounting process to as-
sist in decision making.
Accounting provides information for managers, owners, members, and other stake-
holders who make decisions about organizations. Stakeholders include those who have
an economic interest in an organization and those who are affected by its activities.
An organization is a group of people who work together to develop, produce, and/or
distribute goods or services. The next section of this chapter discusses the purpose of
organizations and the role of accounting in organizations.



THE PURPOSE ORGANIZATIONS
OF
Many types of organizations exist to serve society. Why do these organizations exist?
OBJECTIVE 2
Most exist because people need to work together to accomplish their goals. The goals
Compare major types of are too large, too complex, or too expensive to be achieved without cooperation. All
organizations and explain organizations provide goods and/or services. By working together, people can produce
their purpose. more and better goods and services.
Organizations differ as to the types of goods or services they offer (Exhibit 3). Mer-
chandising (or retail) companies sell to consumers goods that are produced by other
companies. Grocery, department, and hardware stores are examples. Mom™s Cookie
Company is a merchandising company. It purchases merchandise from a bakery and
F6 SECTION F1: The Accounting Information System
5
Accounting and Organizations

sells the merchandise to grocery stores. Manufacturing companies produce goods that
they sell to consumers, to merchandising companies, or to other manufacturing com-
panies. Examples include automobile manufacturers, petroleum refineries, furniture
manufacturers, computer companies, and paper companies. The bakery from which
Mom™s Cookie Company purchases its cookies is a manufacturing company. Service
companies sell services rather than goods. These companies include banks, insurance
companies, hospitals, universities, law firms, and accounting firms. Some companies
may be a combination of types. For example, many automobile dealers are both retail
and service companies. Restaurants are both manufacturing and service companies.


Exhibit 3 Business Nonbusiness
Types of Organizations
Retail


Manufacturing Government




Service
Other Nonprofit



Organizations may be classified by whether or not they attempt to earn a profit.
Profits result from selling goods and services to customers at prices greater than the
cost of the items sold. Organizations that sell their goods and services to make a profit
are business organizations. Governmental and nonprofit organizations, sometimes re-
ferred to as nonbusiness organizations, provide goods or, more typically, services
without the intent of making a profit. Nonbusiness organizations include civic, social,
and religious organizations. Some types of services, such as education and healthcare
services, are provided by both business and nonbusiness organizations. Although the
products are similar, the goals of the organizations providing these services are differ-
ent. Nevertheless, all organizations need accounting information for decision making.
This book focuses primarily on accounting for business organizations.


Transformation of Resources
A common purpose of organizations is to transform resources from one form to a dif-
ferent, more valuable, form to meet the needs of people. Resources include natural re-
sources (such as minerals and timber), physical resources (such as buildings and
equipment), management skills, labor, financial resources, legal rights (such as patents
and trademarks), information, and the systems that provide information. The trans-
formation process combines these resources to create goods and services. Transforma-
tion may involve making goods or services easier or less expensive for customers to
obtain, as in most merchandising and service companies. Or it may involve physically
converting resources by processing or combining them, as in manufacturing compa-
nies. An easy way to understand the transformation of resources is by thinking about
how a bakery takes resources like flour and sugar and transforms them through the
mixing and baking process to become cookies. Exhibit 4 illustrates this transformation
process.
Organizations are created because many transformations are too difficult or too ex-
pensive for individuals to accomplish without working together. By combining their
managerial skills, labor, and money, individuals create organizations to provide value
that otherwise would be unavailable. Value is added to society when an organization
transforms resources from a less desirable form or location to a more desirable form
F7
CHAPTER F1: Accounting and Organizations
6 Accounting and Organizations

Exhibit 4 Transformation Goods and Services
Resources
Transformation of
Resources into Goods
and Services




or location. The transformation, if it meets a need of society, creates value because
people are better off after the transformation than before. For example, a company
that manufactures shirts creates value because the shirts are more useful to those who
purchase them than the material from which the shirts are made or the cotton or syn-
thetic fibers used to make the material.
To improve its welfare, a society must encourage organizations to increase the value
they create. Because resources are in scarce supply, a society should attempt to use its
resources wisely. A major purpose of accounting information is to help decide how to
get the most value from scarce resources.


Creating Value
How can society determine how to use its resources? Decisions about using scarce re-
OBJECTIVE 3
sources wisely are not easy. Because society is made up of many individuals, disagree-
Describe how businesses ment often exists as to how resources should be used. In our society and many others,
create value. markets are the means used to promote the wise use of many resources.
Markets exist to allocate scarce resources used and produced by organizations. A
market is any location or process that permits resources to be bought and sold. Com-
petition in a market determines the amount and value of resources available for ex-
change. The more valuable a resource is in meeting your needs, the more you are willing
to pay for it as a buyer, or the more you want for it as a seller.
The price paid for a resource in a competitive market is an indication of the value
assigned to it at the particular time the buyer and seller negotiate an exchange. For ex-
ample, when you buy a box of cookies, you exchange money for it. The amount of
money is a measure of the value you place on the product. Thus, the price of goods
and services in a market is a basis for measuring value. Accounting measures the in-
crease in value created by a transformation as the difference between the total price
of goods and services sold and the total cost of re-
LEARNING NOTE sources consumed in developing, producing, and
selling the goods and services.
Distinguish between prices charged by a business to its cus-
What value results when you purchase cookies?
tomers and prices paid by a business for resources it consumes.
The amount you pay for the cookies is an indication
A price charged by a business is a sales price. A price paid by
of the value you expect to receive. However, resources
a business to purchase resources that will be consumed in pro-
were consumed in producing the cookies and mak-
viding goods and services is a cost to the business.
ing them available to you as illustrated in Exhibit 5.



Exhibit 5
Value Created by Sales Price of Value Added
Total Cost of Resources
Box of Cookies Consumed to Produce
Transforming Resources
and Make Box of
Cookies Available


$3.00
$3.50 $0.50
F8 SECTION F1: The Accounting Information System
7
Accounting and Organizations

If you pay $3.50 for a box of cookies and the total cost of producing the cookies
and making them available to you is $3.00, the value added by the transformation is
$0.50. The difference between the price you pay and the total cost of the cookies is profit
for those who produce and sell the cookies. Profit is the difference between the price
a seller receives for goods or services and the total cost to the seller of all resources
consumed in developing, producing, and selling these goods or services during a par-
ticular period. Thus, profits are the net resources generated from selling goods and ser-
vices (resources received from the sales minus resources used in making the sales).
Several types of markets are important in our economy. Markets exist for resources
used by organizations. Organizations compete in financial markets for financial re-
sources. Investors choose where to put their money to work by selecting among com-
peting organizations. Organizations compete in supplier markets for other resources
needed to produce goods and services. Competition in these markets determines the
costs of materials, labor, equipment, and other resources available to organizations. Or-
ganizations compete in product markets (markets for goods and services). These mar-
kets determine the prices of goods and services available to customers. From the
perspective of organizations, financial and supplier markets are input markets; prod-
uct markets are output markets. All of these markets allocate scarce resources.
Exhibit 6 reports the actual profit earned by Mom™s Cookie Company in January, its
first month of operations. (Keep in mind, the information presented earlier was the esti-
mated amount of sales, costs, and profit.) The profit of $1,700 represents the difference
between the amount of resources created by selling goods to customers and the total cost
of resources consumed in providing those goods. Of course, a business venture may not
produce a profit. It produces a loss if it consumes more resources than it creates.



Exhibit 6
Mom™s Cookie Company
Profit Earned by Mom™s
Profit Earned
Cookie Company in
For January
January
Resources created from selling cookies $11,400
Resources consumed:
Cost of merchandise sold $7,600
Wages 1,000
Rent 600
Supplies 300
Utilities 200
Total cost of resources consumed 9,700
Profit earned $ 1,700




This exhibit reports results of activities that occurred during January. These results
can be compared with expected results. Mom™s Cookie Company had sales of $11,400
compared with expected sales of $12,000. The cost of merchandise sold during Janu-
ary was $7,600 rather than the expected amount of $8,000, and profit earned by the
company was $1,700 rather than the expected amount of $1,900. By examining the dif-
ferences between expected and actual results, Maria and Stan can determine whether
they need to make changes in their business. Perhaps they need to find more stores to
sell their products, or perhaps they need to advertise their products.


THE ROLE ACCOUNTING BUSINESS ORGANIZATIONS
OF IN
Businesses earn profits by providing goods and services demanded by society. Owners
invest in a business to receive a return on their investments from profits earned by their
business. By investing in a business, owners are forgoing the use of their money for
F9
CHAPTER F1: Accounting and Organizations
8 Accounting and Organizations

other purposes. In exchange, they expect to share in a business™s profits. Return on in-
OBJECTIVE 4
vestment (ROI) is the amount of profit earned by a business that could be paid to
Explain how accounting owners. Return on investment often is expressed as a ratio that compares the amount
helps investors and other of profit to the amount invested in a business by its owners:
decision makers under-
stand businesses. Profit
Return on Investment
Amount Invested

Profits represent net resources that have been earned through sales transactions. A
business may distribute profits to its owners. Alternatively, owners (or managers act-
ing on their behalf) may decide to reinvest profits in a business to acquire additional
resources. The business can use the additional resources to earn more profits by ex-
panding its size or by expanding into new locations or product lines. Either way, the
owners are usually better off. They receive cash from their investments if profits are
withdrawn, or they add value to the business if profits are reinvested.
As shown in Exhibit 6, Mom™s Cookie Company earned $1,700 during January. As
the owners, Maria and Stan may choose to withdraw some or all of this amount for
personal use. It is their return on investment. Alternatively, they might choose to rein-
vest all or a portion of this profit to enlarge their company by buying a larger amount
of merchandise for sale in February.
Return on investment for Mom™s Cookie Company for January was $1,700, or 17%
($1,700 $10,000), relative to the owners™ initial investment. If Maria and Stan with-
draw more than $1,700 from their business, the additional amount withdrawn is a re-
turn of investment, not a return on investment. That additional amount is a return of
a portion of the amount they originally invested. For a company to maintain its cap-
ital (the amount invested by its owners), it must pay a return to owners from prof-
its the company has earned. Otherwise, the company is reducing its capital by
returning a portion of owners™ investments to them.
The amount of return owners receive from a company depends on the company™s
success in earning a profit. If you are the primary owner of a business, you are actively
involved in managing the business, and its success depends largely on your ability and
effort. If you are one of many who invest in a company, you probably are not actively
involved in the business, and its success depends largely on the abilities and efforts of
those who are managing the business. When you invest in a business, you have no guar-
antee that it will be successful. You are taking a risk that you may not receive a return
on your investment, that the return may be smaller than you expected, or even that you
might lose your investment.
Why invest in a business if the investment is risky? If a business is successful, its
owners can expect to earn a higher rate of return on their investments than they could
earn on a safer alternative, such as a savings account. By investing $10,000 in Mom™s
Cookie Company, Maria and Stan expect to earn $1,900 each month from their in-
vestment. If they invested their money in a savings account, they would expect to earn
$50 each month. In general, it is necessary to take greater risks in order to earn higher
returns. Accounting information helps owners evaluate the risks and returns associated
with their investments so they can make good decisions.
To earn profits and pay returns to owners, businesses must operate effectively and
efficiently. An effective business is one that is successful in providing goods and ser-
vices demanded by customers. Effective management involves identifying the right
products and putting them in the right locations at the right times. An efficient busi-
ness is one that keeps the costs of resources consumed in providing goods and ser-
vices low relative to the selling prices of these goods and services. Managers must
control costs by using the proper mix, qualities, and quantities of resources to avoid
waste and to reduce costs. The risk of owning a business is lower if the business is ef-
fective and efficient than if it is ineffective or inefficient. Efficient and effective busi-
nesses are competitive in financial, supplier, and product markets.
Mom™s Cookie Company will be effective if it sells products desired by customers
and if the products are made available in locations convenient for customers to purchase
them. The company will be efficient if it can keep the costs of resources it consumes low
F10 SECTION F1: The Accounting Information System
9
Accounting and Organizations

relative to the price of the goods it sells. During January, the company was less effective
than Maria and Stan had planned because it sold fewer goods than expected. The com-
pany was efficient in controlling the cost of resources consumed because its costs were
less than the prices of goods sold, thus permitting the company to earn a profit.
Business owners expect to receive a return on their investments. Investors choose
among alternative investments by evaluating the amount, timing, and uncertainty of
the returns they expect to receive. Businesses that earn high profits and are capable of
paying high returns have less difficulty in obtaining investors than other businesses. A
business that cannot earn sufficient profits will be forced to become more effective and
efficient or to go out of business.
The accounting information system is a major source of the information investors
use in making decisions about their investments. Accounting information helps in-
vestors assess the effectiveness and efficiency of businesses. It helps them estimate the
returns that can be expected from investing in a business and the amount of risk asso-
ciated with their investments. Financial, supplier, and product markets create incen-
tives for businesses to provide products that society demands. These markets help ensure
that scarce resources are used to improve society™s welfare. Markets help allocate scarce
resources to those organizations that can best transform them to create value.
Accounting is an information system for the measurement and reporting of the
transformation of resources into goods and services and the sale or transfer of these
goods and services to customers. Accounting uses the prices and costs of resources to
measure value created by the transformation process and to trace the flow of resources
through the transformation process. By tracing the flow of resources, managers and other
decision makers can determine how efficiently and effectively resources are being used.




1 SELF-STUDY PROBLEM John Bach owns a music store in which he sells and repairs mu-
sical instruments and sells sheet music. The following transactions
occurred for Bach™s Music Store during December 2004:
1. Sold $8,000 of musical instruments that cost the company $4,300.
2. Sold $1,400 of sheet music that cost the company $870.
3. The price of repair services provided during the month was $2,200.
4. Rent on the store for the month was $650.
5. The cost of supplies used during the month was $250.
6. The cost of advertising for the month was $300.
7. The cost of utilities for the month was $200.
8. Other miscellaneous costs for December were $180.

Required
A. Determine the profit earned by Bach™s Music Store for December.
B. Explain how profit measures the value created by Bach™s Music Store.
The solution to Self-Study Problem 1 appears at the end of the chapter.




THE STRUCTURE BUSINESS ORGANIZATIONS
OF
Many types of decisions are made in organizations. Accounting provides important in-
OBJECTIVE 5
formation to make these decisions. For example, organizations require financial re-
sources to buy other resources used to produce goods and services. Primary sources of
Identify business owner-
ship structures and their financing for businesses are owners and creditors.
advantages and disadvan-
tages.
Business Ownership
Businesses may be classified into two categories: those that are distinct legal entities
apart from their owners and those that are not distinct legal entities. A corporation is
F11
CHAPTER F1: Accounting and Organizations
10 Accounting and Organizations

a legal entity with the right to enter into contracts; the right to own, buy, and sell
property; and the right to sell stock. Resources are owned by the corporation rather
than by individual owners.
Corporations may be very large or fairly small organizations. Small corporations
often are managed by their owners. The owners of most large corporations do not man-
age their companies. Instead, they hire professional managers. These owners have the
right to vote on certain major decisions, but they do not control the operations of their
corporations on a day-to-day basis. One reason most large businesses are organized as
corporations is that corporations typically have greater access to financial markets than
other types of organizations.
A corporation may be owned by a large number of investors who purchase shares
of stock issued by the corporation. Each share of stock is a certificate of ownership
that represents an equal share in the ownership of a corporation. An investor who
owns 10% of the shares of a corporation owns 10% of the company and has a right to
10% of the return available to stockholders. Stockholders, or shareholders, are the own-
ers of a corporation.
Shares of stock often are traded in stock markets, such as the New York, London,
and Tokyo stock exchanges, which are established specifically for this purpose. These
markets facilitate the exchange of stock between buyers and sellers. Therefore, unlike
other businesses, ownership in many corporations changes frequently as stockholders
INTERNATIONAL
buy or sell shares of stock. Major corporations, such as General Motors, Exxon, or
IBM, have received billions of dollars from stockholders.
Percentage of
Proprietorships and partnerships are business organizations that do not have legal
Companies and
identities distinct from their owners. Proprietorships have only one owner; partnerships
Volume of Sales by
have more than one owner. For most proprietorships
Type of Organization
and partnerships, owners also manage the business.
Owners have a major stake in the business because of-
ten much of their personal wealth is invested in it. The
amount of a proprietor™s personal wealth and his or her
73% 91% 4%
ability to borrow limit the size of a proprietorship. If a
5%
proprietorship is profitable, profits earned by the pro-
21% prietor can be reinvested, and the business can become
fairly large.
6%
Partnerships can include several partners; there-
fore, the money available to finance a partnership de-
pends on the money available from all the partners.
Total Companies Total Sales
New partners can be added, making new money avail-
able to the business. While most partnerships are small,
Proprietorship large businesses (with as many as a thousand or more
owners) sometimes are organized as partnerships. The
Partnership
profit of most proprietorships and partnerships is not
taxed. Instead, the profit is income for the owners, who
Corporation
pay income taxes on the profit as part of their personal
income taxes.
(Data source: U.S. Census Bureau Web site (http://www.census.gov)




Management of Corporations
Exhibit 7 describes the organizational structure of a typical corporation. A board of di-
rectors oversees the decisions of management and is responsible for protecting the in-
terests of stockholders. Normally, the board is appointed by management with the
approval of stockholders. Top managers often serve on the board along with outside
directors who are not part of the corporation™s management. The chairman of the board
often holds the position of chief executive officer (CEO) with the ultimate responsi-
bility for the success of the business. The president, as chief operating officer (COO),
is responsible for the day-to-day management of a corporation. In some cases, the pres-
ident also may be the CEO. The company may appoint any number of vice presidents,
F12 SECTION F1: The Accounting Information System
11
Accounting and Organizations

who are responsible for various functions in the organization. The titles and roles of
these managers will vary from corporation to corporation. Along with the CEO and the
president, the vice presidents constitute the top management of a corporation. Together,
they make planning decisions and develop company goals and policies.


Exhibit 7
Board of Directors,
Corporate Management
Chief Executive Officer,
Functions
President,
Other Top Management



Support Functions
Legal Information
Services Systems
Accounting
Financing


Human
Design Resources
The
Company
Purchasing
Research



Production Servicing

Distribution Marketing

Primary Functions



Functions performed within a corporation may be separated into support func-
tions and primary functions. Support functions assist the primary functions by pro-
viding information and other resources necessary to produce and sell goods and
services. Primary functions are those actually involved in producing and selling goods
and services. These functions include distribution of goods and services to customers
and servicing the goods and services to meet customer needs.
Among the support functions are research and development, product and pro-
duction design, finance, legal services, accounting, purchasing, and human resources.
The chief financial officer (CFO), who also may be the treasurer, is responsible for
obtaining financial resources and managing a corporation™s cash. The controller, as
the chief accounting officer, is responsible for accounting and financial reporting, de-
veloping and maintaining the accounting information system, and reporting to tax
and regulatory authorities.
Primary functions involve production, distribution, sales, and service. Plant man-
agers oversee production for specific product lines or geographical locations. These
managers often have their own staffs at the divisional or plant level. For example, di-
visional or plant level controllers exist in many corporations. Research, design, and
development staffs also exist at the divisional or plant level in some organizations.
Corporations may be organized by functions such as those described in Exhibit
7. Other corporations are organized primarily by region or product line. For exam-
ple, multinational companies may be organized into North American, European, and
Pacific divisions. Functional areas, such as development and production, report to re-
gional or product managers. Many corporations are finding advantages in changing
from a traditional organization structure to teams of managers working together on
specific projects. Thus, the idea for a new product may be the responsibility of a team
F13
CHAPTER F1: Accounting and Organizations
12 Accounting and Organizations

of employees from a company™s functional areas, such as engineering, accounting, and
marketing. Together, the team decides on a design for the product and on a produc-
tion process to create efficiency and product quality.


Advantages of Corporations
A corporate form of organization has several advantages over proprietorships or part-
nerships. Corporations have continuous lives apart from those of their owners. If a
proprietor or partner sells her or his share of a business or dies, the business ceases
to exist as a legal entity. The new owner of the business must reestablish the business
as a new legal entity. Most corporations, however, continue unchanged if current
owners sell their stock, donate it to charity, give it to relatives, or otherwise dispose
of their shares.
Shareholders normally are not liable personally for the debts of a corporation. This is
a characteristic known as limited liability. If a corporation defaults on debt or enters bank-
ruptcy, its owners may lose a portion or all of their investments in the company, but they
are not obligated to use their personal wealth to repay creditors for losses the creditors in-
curred. In many cases, proprietors and partners are personally liable for the debts of their
companies and can be required to use their personal wealth to repay their creditors.
Shareholders of most corporations do not man-
age the company. They elect members of the board of
LEARNING NOTE
directors, who then hire professional managers to run
A partnership can be organized as a limited liability partner-
the corporation. Investors can own part of a corpora-
ship (LLP). The LLP restricts the personal liability of each part-
tion or parts of many corporations without having to
ner for obligations created by the company. Many professional
participate in the day-to-day decisions of running
service companies, particularly accounting and legal firms, are
those companies. Many Americans own stock in cor-
organized as LLPs. A business also can be organized as a lim-
porations through personal investments and retire-
ited liability company (LLC). An LLC combines certain advan-
ment plans, but they are not required to commit large
tages of a partnership and a corporation in that it combines the
amounts of their personal time to corporate concerns.
tax treatment of a partnership with the limited liability of corpo-
Shareholders cannot enter into contracts or
rations. While a corporation can have as few as one shareholder,
agreements that are binding on a corporation unless
an LLC usually must have at least two owners. Both LLPs and
they are managers or directors. Therefore, investors
LLCs are separate legal entities from their owners.
in a corporation do not have to be concerned about
the abilities of other stockholders to make good busi-
ness decisions. In contrast, bad decisions by one partner can result in the personal bank-
ruptcy of all partners in a partnership. This problem arises because partners normally
are in a mutual agency relationship. Mutual agency permits a partner to enter into
contracts and agreements that are binding on all members of a partnership.
By selling shares to many investors, a corporation can obtain a large amount of fi-
nancial resources. The ability to raise large amounts of capital permits corporations to
become very large organizations. Thus, corporations can invest in plant facilities and un-
dertake production activities that would be difficult for proprietorships or partnerships.


Disadvantages of Corporations
There are several disadvantages to the corporate form of ownership. Most corporations
must pay taxes on their incomes. Corporate taxes are separate from the taxes paid by
shareholders on dividends received from the company. (Some corporations, however,
especially smaller ones, are not taxed separately.) Another disadvantage is that corpo-
rations are regulated by various state and federal government agencies. These regula-
tions require corporations to comply with many state and federal rules concerning
business practices and reporting of financial information. Corporations must file many
reports with government agencies and make public disclosure of their business activi-
ties. Compliance with these regulations is costly. Also, some of the required disclosures
may be helpful to competitors. Partnerships and proprietorships are regulated also, but
the degree of regulation normally is much less than for corporations.
F14 SECTION F1: The Accounting Information System
13
Accounting and Organizations

Owners of corporations usually do not have access to information about the day-
to-day activities of their companies. They depend on managers to make decisions that
will increase the value of their investments. However, managers™ personal interests
sometimes conflict with the interests of stockholders. This problem produces a condi-
tion known as moral hazard. Moral hazard arises when one group, known as agents
(such as managers), is responsible for serving the needs of another group, known as
principals (such as investors). Moral hazard is the condition that exists when agents
have superior information to principals and are able to make decisions that favor
their own interests over those of the principals.
Without disclosure of reliable information, corporations would have difficulty in
selling stock, and investors would be unable to determine whether managers were mak-
ing decisions that increased stockholder value or were making decisions that took ad-
vantage of the stockholders. Accounting reports are major sources of information to
help stockholders assess the performance of managers. For example, profit information
helps owners evaluate how well managers have used owners™ investments to earn re-
turns for the owners. Moral hazard imposes costs on corporations because managers
must report to stockholders and, generally, these reports are audited. An audit verifies
the reliability of reported information.
The size of many corporations makes them difficult to manage. An individual man-
ager cannot be involved directly with all the decisions made in operating a large organi-
zation. Top-level managers depend on low-level managers to make decisions and to keep
them informed about a corporation™s operations. This process is costly because coordi-
nation among managers may be difficult to achieve. Moral hazard also exists among man-
agers and employees, not just between managers and investors. Corporate goals and
policies provide guidance for manager decisions, but communicating goals and policies
and providing incentives for managers to implement them often is difficult and expen-
sive. Employees and low-level managers may not report reliable information about their
activities to high-level managers if the information is not in their best interests. Multina-
tional corporations, in particular, are complex and difficult to manage. Distant locations
for facilities and differences in language and local custom can cause special problems.
The profits of corporations, except for those of small privately-owned ones, referred
to as Subchapter S corporations, are taxed separately from taxes paid by the owners of
the corporation. The federal government and most state governments impose a corpo-
rate income tax on the profits of corporations. This tax is paid by the corporation. In
addition, amounts distributed to shareholders are taxed as part of their personal in-
come. Thus, the profits of corporations often are subject to double taxation: taxation
of the corporation and taxation of the shareholders.


Creditors
In addition to money provided by owners, businesses (and other organizations) may
borrow money. Money may be obtained from banks and other financial institutions,
or it may be borrowed from individual lenders. A creditor is someone who loans fi-
nancial resources to an organization.
Most organizations depend on banks and similar institutions to lend them money.
Corporations often borrow money from individuals or other companies. Exhibit 8
shows the amount of money several large corporations have received from owners and
creditors. The amounts and proportions of financing from owners and creditors vary
greatly across companies.
Creditors loan money to organizations to earn a return on their investments. They
usually loan money for a specific period and are promised a specific rate of return on
their investments. Usually, this is a fixed rate (say 10%). In contrast, owners invest for
a nonspecific period (until they decide to sell their investments) and receive a return
that depends on the profits earned by the business.
The success of a business determines whether creditors will receive the amount
promised by the borrower. When a business fails to generate sufficient cash from selling
F15
CHAPTER F1: Accounting and Organizations
14 Accounting and Organizations

Exhibit 8 100
Data source: 2001 annual reports.
Sources of Financing for
90
Selected Corporations
Creditors
80
Owners
70

60


Percent
50

40

30

20

10

0
Ford Microsoft PepsiCo. Wal-Mart
Motor
Co.



goods and services to pay for resources it consumes and to pay its creditors, the cred-
itors may not receive the amount promised. Therefore, creditors estimate the proba-
bility that an organization will be able to repay debt and interest. Risk is a concern of
both creditors and owners, and accounting information is key in evaluating the risk.
Exhibit 9 illustrates the role of owners and creditors in providing financial resources
for businesses.


Exhibit 9
Owners Creditors
Obtaining Financial
Resources
Proprietorship
Financial
Institutions*
or


+
Partnership

Financial
or
Resources
Individuals
Corporation



*The term “financial institutions” refers to banks, savings and loans, and similar companies.




2 SELF-STUDY PROBLEM Hammer Hardware Company and Home Depot are both retail
stores that sell tools, hardware, and household items. Hammer
Hardware is owned by Harvey Hammer and is organized as a proprietorship. Home
Depot is organized as a corporation and is owned by thousands of investors.
F16 SECTION F1: The Accounting Information System
15
Accounting and Organizations

Required Why is the form of ownership different for these companies? What are the
advantages and disadvantages of each form?
The solution to Self-Study Problem 2 appears at the end of the chapter.




ACCOUNTING BUSINESS DECISIONS
AND
The value of accounting information is determined by how well it meets the needs of
OBJECTIVE 6
those who use it. Accounting information describes economic consequences of the
Identify uses of account- transformation process. Information needs of decision makers arise from the many re-
ing information for lationships that occur within the transformation process among an organization™s stake-
making decisions about holders: managers, investors, suppliers, employees, customers, and government
corporations. authorities. These stakeholders compete in markets for resources, or they regulate these
markets. They exchange resources or services with an organization as part of its trans-
formation process.
Contracts are legal agreements for the exchange of resources and services. They
provide legal protection for the parties to an agreement if the terms of the agreement
are not honored. Contract terms establish the rights and responsibilities of the con-
tracting parties. Contracts are “give and get” relationships. Each party to the contract
expects to receive something in exchange for something given. For example, a contract
by an employee to provide labor to a company involves the giving of labor services by
the employee in exchange for wages and benefits. Contracts with proprietorships and
partnerships are between the owners/managers and other contracting parties. In con-
trast, because corporations are legal entities, contracts can be formed with the corpo-
ration as one of the contracting parties. Managers make contracts on behalf of
corporations and their owners.
Contracts are enforceable only to the extent that contracting parties can determine
whether the terms of the contract are being met. Assume that you sign a contract with
a company that calls for you to invest $1,000 in the company and for the company to
pay you 10% of the amount the company earns each year. Unless you have reliable in-
formation about the company™s earnings, you cannot determine whether it is paying
you the agreed amount. Therefore, you probably would not agree to the contract. Con-
tracts require information that the contracting parties accept as reliable and sufficient
for determining if the terms of the contract have been met. Accounting information
is important for forming and evaluating contracts.
Exhibit 10 identifies examples of exchanges among stakeholders for which contracts
and information about organizations are important. The following sections discuss these
exchanges.


Risk and Return
LEARNING NOTE
Contracts are formed to identify rights and respon-
Products can be either goods or services or both. While often we
sibilities. These rights and responsibilities establish
talk about companies that sell goods, you should keep in mind
how risk and return will be shared among contract-
how accounting is important to service companies also.
ing parties. Information about risk and return is
needed to determine contract terms. Return is the
amount a party to a contract expects as compensation for the exchange outlined in the
contract. As noted earlier in this chapter, risk is uncertainty about an outcome; it re-
sults from uncertainty about the amount and timing of return. Exhibit 11 describes the
returns of two investments (A and B) over several time periods. Which investment is
riskier? Returns for investment A are relatively stable and predictable; they are grow-
ing at a steady rate. Returns for investment B are less predictable. Investment B is riskier
than A, although it may produce higher returns over time than A.
Those who invest in a company expect to earn returns on their investments. At the
same time, they must evaluate the risk inherent in investing in the company. What
F17
CHAPTER F1: Accounting and Organizations
16 Accounting and Organizations

Exhibit 10
The Organization
Examples of Exchanges
Requiring Information
Money
Obtain Money Investors
Money
Acquire
Resources
Money
Managers & Employees
Produce and Services
Sell Goods
and Services
Money
Suppliers
Materials

Products
Customers
Money

Money
Government Agencies
Services




Exhibit 11 Returns
An Illustration of Risk
Time Period Investment A Investment B
and Return
1 $6 $10
2 6 12
3 7 7
4 7 3
5 8 8
6 8 11




should they earn if the company does well? What might happen if the company does
poorly? Risk and return are related in most situations; investors expect to earn higher
returns on riskier investments. The higher returns compensate them for accepting
higher risk. However, actual returns may differ from expected returns, and so riskier
investments may actually result in higher or lower returns than less risky investments.
On average, however, higher return should be associated with greater risk; otherwise,
investors will not participate in risky investments. Accounting information helps in-
vestors predict risk and return associated with investments. The following sections con-
sider the risk and return evaluations made by those who contract with an organization.

Investors and Creditors. Investors and creditors contract with companies to provide
financial resources in exchange for future returns. They need information to decide
whether to invest in a company and how much to invest. Accounting information
helps investors evaluate the risk and return they can expect from their investments.
Also, it helps them determine whether managers of companies they invest in are meet-
ing the terms of their contracts.
If a company does not earn sufficient profits, it may be unable to repay its cred-
itors, and creditors can force a company to liquidate (sell all its noncash resources)
to repay its debts. On the other hand, if a company is profitable, stockholders (in-
vestors) normally earn higher returns than creditors because stockholders have a right
to share in a company™s profits. Creditors receive only the amount of interest agreed
to when debt is issued. Consequently, investors and creditors choose between risk
and return.
F18 SECTION F1: The Accounting Information System
17
Accounting and Organizations

Managers. Owners generally do not manage large corporations. Instead, they hire
managers who operate the businesses for them. Managers contract with owners to pro-
vide management services in exchange for salaries and other compensation. Owners,
or directors who represent them, need information to determine how well managers
are performing and to reward managers when they do well. To provide incentives for
managers to perform well, owners may offer managers bonuses when a company is
profitable. Accounting information provides a means for owners and managers to de-
termine the amount of compensation managers will receive.
Compensation arrangements also encourage managers to present their companies™
performances in the best light. Often, compensation is linked to profits and other ac-
counting information, giving managers incentives to report numbers that will maxi-
mize their compensation. The combination of management control over information
and manager incentives to make their companies look good provides an ethical dilemma
for managers. Sometimes, they must choose between the company™s best interests and
their own best interests.



Case In Point
Moral Hazard”Mismanagement by Managers
In 2001, Enron Corporation, the seventh largest U.S. corporation at the time, declared
bankruptcy after revealing that its profits had been overstated for several years and
that it had failed to report large amounts of debt. The debt was used by the corpora-
http://ingram. tion to expand its business operations into new markets and products. Some of these
swlearning.com new ventures resulted in losses that were not properly reported by the corporation™s
management. When revealed, these losses made it difficult for the corporation to ob-
Learn more about
tain additional financing, and it was unable to meet its debt obligations. As a result of
Enron.
these events, the market value of the corporation decreased dramatically, creating
losses for many investors. Many employees lost their jobs and retirement savings, and
many creditors were unable to collect amounts owed them.
Enron™s investors and creditors sued the company™s managers, claiming that they
had been misled by information reported by the managers. The managers had earned
high salaries and other compensation associated with the high profitability and growth
they reported for the company. Investors and creditors, and many members of Con-
gress who investigated the collapse of Enron, argued that managers had profited by
operating the business for personal gain rather than for the benefit of the company™s
owners.




Decisions by managers have a direct effect on the risk and return of those who con-
tract with a company. Managers decide which resources to acquire, when to acquire
them, and how much to pay for them.
Each investment in a resource involves decisions about the risk and return associ-
ated with the investment. An organization is a portfolio (collection) of individual re-
sources. In combination, the risks and returns on the investments in these resources
help determine the risk and return of the organization as a whole. One task of man-
agement is to select a portfolio of resources that will yield a desired amount of return
at a level of risk that managers and owners find acceptable. Investments in proven tech-
nology and established products generally are less risky than investments in new tech-
nology or products. Investments in resources in some countries are riskier than those
in other countries because of those countries™ political and economic environments.
Accounting information is useful for identifying the types and locations of an orga-
nization™s resources.
A major purpose of accounting is to measure costs associated with the flow of
resources through the transformation process. Accounting also measures resources
obtained from selling goods and services. The profits earned by a corporation are a
F19
CHAPTER F1: Accounting and Organizations
18 Accounting and Organizations

major determinant of risk and return. Information about the results of the opera-
tions of a business is used to estimate, compare, and manage companies™ risks and
returns.

Employees. Employees have a major effect on a company™s risk and return. Wages
and quality of work directly affect product quality, sales, costs, and profits. Companies
evaluate the cost and productivity of their employees. They compare employee perfor-
mance with management expectations, examine changes over time, and compare dif-
ferent divisions with each other. Accounting information helps managers assess
employee performance.
Employees negotiate for wages, benefits, and job security. Compensation is af-
fected by a company™s performance and financial condition. Labor unions and other
employee groups use accounting information to evaluate a company™s ability to com-
pensate its employees. Like other contracting parties, employees evaluate risk and re-
turn in an employment relationship. If a company does well, employees expect to be
rewarded. If it does poorly, they may face layoffs, wage and benefit cuts, and loss of
jobs. Accounting information helps employees assess the risk and return of their
employment contracts.

Suppliers. An organization purchases materials, merchandise, and other resources
from suppliers. These resources are a major cost for most companies. Careful negotia-
tion of prices, credit, and delivery schedules between management and suppliers is re-
quired. If a company cannot obtain quality materials when they are needed, it may incur
major losses as a result of idle production, waste, lost sales, and dissatisfied customers.
If a supplier goes out of business or cannot fulfill its commitments, a company may
have difficulty obtaining needed resources. Accounting information helps companies
evaluate the abilities of their suppliers to meet their resource needs.
Suppliers often sell resources to companies on credit. These suppliers are creditors
who are financing the sale of resources to a company in anticipation of future pay-
ments. Usually, these loans are for short periods (30 to 60 days), although longer fi-
nancing sometimes is arranged. When a company is not profitable, its suppliers may
have difficulty collecting the amounts owed them. Therefore, suppliers evaluate the risk
they are taking in selling on credit to other companies. Suppliers often use account-
ing information about their customers to evaluate the risk of a buyer not being able
to pay for goods and services acquired.

Customers. A company is a supplier to its customers. Thus, it evaluates customers in
the same way it is evaluated by suppliers. Managers decide the terms of sales by evaluat-
ing the risk and return associated with the sales. Riskier customers normally receive less
favorable terms. For example, a customer with good credit can purchase a house, car, ap-
pliances, and other goods on more favorable terms than can a customer with bad credit.
Customers™ decisions to buy products often are affected by their perception of qual-
ity and dependability, as well as price. These decisions also may depend on the finan-
cial reputation of the seller. Will the company be in business in the future when
maintenance, repair, or replacement is needed? Will it be able to honor warranties? Are
its profits sufficient to invest in new technology and maintain quality products? Ac-
counting information is used to assess the risks of buying from specific companies
and selling to specific customers.

Government Agencies. Organizations are required to provide information to gov-
ernment agencies. Governments require businesses to purchase licenses for selling goods
and services and to pay fees and taxes for various government services. Often these
amounts are determined by the amount of sales or the profitability of an organization.
Governments collect information about organizations as a basis for economic forecasts
and planning at the local, state, and national levels. Businesses are required to report
information to state and federal authorities that regulate business activities to ensure
fair trade, fair treatment of employees, and fair disclosure to investors.
F20 SECTION F1: The Accounting Information System
19
Accounting and Organizations

Businesses report information to taxing authorities at various levels of government.
Reports are required in filing sales, property, payroll, excise, and income taxes. The
amount of these taxes is determined by a company™s sales, the costs it incurs, and
amounts paid to employees. Government agencies use accounting information to
make taxation and regulatory decisions.



THE REGULATORY ENVIRONMENT ACCOUNTING
OF
Accounting information prepared for use by external decision makers is financial ac-
OBJECTIVE 7
counting information. Financial accounting is the process of preparing, reporting,
and interpreting accounting information that is provided to external decision mak-
Explain the purpose and
importance of accounting ers. It is a primary source of information for investors and creditors. Thus, it is very
regulations. important to the organization when it wants to obtain resources from those external
decision makers. It also may affect the decisions of suppliers, customers, and employ-
ees. Because of concerns about information reliability and moral hazard, managers of
major corporations prepare financial accounting information according to specific rules
called generally accepted accounting principles (GAAP). GAAP are standards devel-
oped by professional accounting organizations to identify appropriate accounting
and reporting procedures. GAAP establish minimum disclosure requirements and in-
crease the comparability of information from one period to the next and among dif-
ferent companies.
This textbook emphasizes financial accounting
LEARNING NOTE for corporations. Moral hazard resulting from the
separation of owners and managers has led to the cre-
GAAP apply only to information prepared for use by external de-
ation of a strong regulatory environment for corpo-
cision makers. Because managers control information available
rations. This environment oversees the development
inside an organization, accounting standards such as GAAP are
of accounting and reporting requirements for corpo-
not necessary for this information.
rations. We will examine this environment and the
resulting requirements.
Financial accounting usually is distinguished from managerial accounting. Man-
agerial (or management) accounting is the process of preparing, reporting, and in-
terpreting accounting information that is provided to internal decision makers.
Because managers have control over the information they use internally, this informa-
tion does not have to be prepared according to GAAP. Accounting information re-
ported by managers to owners and other external decision makers is the subject of
financial accounting. It is important to keep in mind,
however, that this information also is used by man-
LEARNING NOTE
agers. Although managers have access to information
Managers, as internal decision makers, use financial accounting
that extends beyond that reported to external deci-
information to evaluate the performance of their companies. Also,
sion makers, internal and external decisions are re-
they are concerned about the effect of financial accounting in-
lated. Therefore, this book will consider internal and
formation on the decisions of the other stakeholders because
external decisions that rely on financial accounting
these decisions can affect their companies.
information.
Accounting information reported by corpora-
tions to investors must be audited. An audit is a detailed examination of an organi-
zation™s financial reports. It includes an examination of the information system used
to prepare the reports and involves an examination of control procedures organiza-
tions use to help ensure the accuracy of accounting information. The purpose of an
audit is to evaluate whether information reported to external decision makers is a fair
presentation of an organization™s economic activities. Standards (GAAP) for the
preparation and reporting of information help ensure the reliability of accounting in-
http://ingram. formation. The auditors, who are independent certified public accountants (CPAs),
swlearning.com examine this information to confirm that it is prepared according to GAAP. To be a
CPA, a person must pass a qualifying exam and meet education and experience re-
Learn more about the
quirements. CPAs are independent of the companies they audit because they are not
CPA exam.
F21
CHAPTER F1: Accounting and Organizations
20 Accounting and Organizations

company employees. Rather, they work for an accounting firm that is hired by the
company™s owners to perform the audit. In the case of a corporation, it is the board
of directors, with the approval of stockholders, that hires the auditor. Also, CPAs
should have no vested interests in the companies that might bias their audits.
Many corporations must report audited financial
accounting information to governmental agencies.
LEARNING NOTE
Corporations whose stock is traded publicly in the
GAAP apply to all business organizations. As long as accounting
United States report to the Securities and Exchange
information produced by the business is used for internal pur-
Commission (SEC). This agency examines corporate
poses only, the company™s managers can elect whether or not
financial reports to verify their conformance with
that information complies with GAAP. Conformity with GAAP is
GAAP and SEC requirements. If the SEC believes a
required for information produced for external users, such as
company™s reports have not been prepared in con-
creditors. Many privately-owned businesses are audited because
formance with GAAP, it can refer the company to the
they are required to provide accounting information to banks and
Justice Department for criminal and civil charges. In
other financial institutions that lend money to the businesses.
addition, the corporation™s auditors can be prose-
cuted if they fail to meet their responsibilities for en-
suring that a corporation™s reports are a fair representation of its economic activities.


Case In Point
Auditor Responsibility
Enron Corporation™s audit firm, Andersen, was investigated for its role in the misstate-
ment of Enron™s financial information. The audit firm admitted that it made mistakes in
the audit but argued that Enron™s managers had failed to report fully to the auditors about
http://ingram. its questionable business activities. Andersen also was charged by the Federal govern-
swlearning.com ment with destroying information that would have assisted the government in its inves-
tigation of Enron™s activities. In addition, this industry leader can no longer perform SEC
Learn more about audi-
audits. Consequently, Andersen lost a major portion of its business as former clients
tor responsibilities.
awarded their audits to other audit firms and as many Andersen employees left the firm.
Critics also questioned Andersen™s independence in the audit because the firm
earned large consulting fees from Enron. The critics argued that Andersen did not press
Enron for proper disclosure of its business activities for fear that it would lose Enron
as a client, thereby losing the consulting fees in addition to its audit fees. It is impor-
tant that audit firms be perceived as being independent of their clients, in addition to
actually being independent. Auditors must continuously assess their independence.




Financial accounting is critical for the operations of a market economy. Full and
fair disclosure of business activities is necessary for stakeholders to evaluate the returns
and risks they anticipate from investing in and contracting with business organizations.
Capital markets, markets in which corporations obtain financing from investors, in
particular, require information that permits investors to assess the risks and returns of
their investments. If that information is not available or is unreliable, investors are un-
able to make good decisions. Without reliable information about companies™ busi-
ness activities, investors cannot determine which companies are most efficient and
effective and are making the best use of resources. Consequently, resources may be al-
located to less efficient and effective companies, resulting in a loss of value for society.
Without good information, contracts cannot be evaluated, and markets cannot func-
tion properly. Consequently, accounting plays a critical role in our society. For our so-
ciety to continue to prosper, it is essential that those who make decisions about resource
allocations understand accounting information and how to use that information to eval-
uate business activities. They need to understand how accounting information is created
and the limitations inherent in this information. Failure to understand accounting prop-
erly is likely to lead to poor decisions and unsatisfactory economic outcomes.
This book will help you understand why accounting information is important, how
this information is produced, and how you can use this information to make good
F22 SECTION F1: The Accounting Information System
21
Accounting and Organizations

business decisions. It will help you learn to evaluate business activities and to determine
which companies are operating most efficiently and effectively. It will help you contribute
to improving our society by becoming an informed participant in our market economy.



THE IMPORTANCE ETHICS
OF
Ethics are important in business organizations. Ethics involve living by the norms and
OBJECTIVE 8
rules of society. In business, those norms and rules identify appropriate behavior for
Explain why ethics are managers, employees, investors, and other stakeholders. Keeping their investors and
important for business other stakeholders fully informed about their business activities is an important ethi-
and accounting. cal norm for managers. Managers who conceal their activities or who misrepresent those
activities make it difficult for stakeholders to assess how well a business is performing.
Overstating profits, for example, may result in investors allocating more resources to a
company than actual results would justify. This misallocation results in a loss of value
to society and often leads to financial harm for those who use this information.
Ethical behavior is particularly important for accounting because the reliability
of accounting information depends on the honesty of those who prepare, report, and
audit this information. Managers may make decisions that benefit themselves at a cost
to investors or other stakeholders. If they then attempt to conceal these decisions by
reporting incorrect information, that information is not an accurate description of the
economic activities of a business. If employees steal money or other resources from a
business and the thefts are not detected, the company™s accounting information also
will not properly reflect the company™s economic situation. If those who audit a com-
pany do not ensure that reported information is a fair representation of the company™s
business activities, those who rely on the information are likely to be disadvantaged.
Those who contract with businesses must consider the ethics of those who manage
them. Managers who are willing to bend rules or operate outside of accepted norms are
likely to be untrustworthy. An important role of accounting is to evaluate whether appro-
priate rules are being followed in accounting for reporting business activities. Failure to
follow these rules can result in significant economic consequences, as evidenced by the col-
lapse of Enron Corporation. Generally accepted accounting principles and other account-
ing and auditing rules have been created to help ensure that companies fairly report their
business activities. In addition, corporations and other organizations are required to main-
tain elaborate systems of controls to make it difficult for managers and employees to en-
gage in unethical behavior or misrepresent business activities. We examine ethical issues
and controls throughout this book as we consider proper accounting rules and procedures.




3 SELF-STUDY PROBLEM R. Floorshine is a manufacturer of shoes. The company operates
as a corporation and has issued shares of stock to its owners and
debt to creditors. It has purchased and leased buildings and equipment. It purchases
materials on short-term credit and converts the materials into shoes. The shoes are sold
to retail stores, also on a short-term credit arrangement.

Required Identify the primary exchanges and contracts between the company and its
stakeholders. Describe the primary information needs associated with these exchanges
and contracts.
The solution to Self-Study Problem 3 appears at the end of the chapter.
F23
CHAPTER F1: Accounting and Organizations
22 Accounting and Organizations


A SHORT INTRODUCTION EXCEL
TO
Appendix

This introduction summarizes some of the primary operations and functions of a spread-
sheet. It is intended to get you started if you have not had previous experience with Ex-
cel. There are many operations and functions in addition to those mentioned here.

SPREADSHEET
Identifying and Selecting Cells
A spreadsheet consists of rows and columns. Rows are identified by numbers, and
columns are identified by letters. An intersection of a row and column is a cell. A cell
is identified by the column letter and row number that intersect at that cell.

Columns


Rows Cell A1




To select a cell, click on the cell using the left mouse button. A cell must be selected
before you can enter data or format the cell. Enter data by typing numbers, words, or
characters. Enter numbers without commas. Commas can be added using formatting
procedures described later. An entire row or column can be selected by clicking on the
row or column header. The row header is the leftmost cell in a row that contains the
row number. A column header is the topmost cell in a column that contains the cell
letter. A group of neighboring cells can be selected by clicking with the left mouse but-
ton on the cell in the upper, left corner of the group, then dragging the cursor over all
the cells to be selected.


Referencing and Mathematical Operations
The contents of one or more cells can be referenced in another cell. To reference a cell,
enter the equal sign followed by the cell being referenced. For example, entering A1 in
cell B1 will copy the contents of cell A1 in cell B1. If the contents of cell A1 are changed,
these changes also will appear in cell B1. A common use of cell referencing is to calculate
totals from data in a series of cells. For example, the following spreadsheet contains sales
data for the first three months of a year. The total appears in cell B5. To calculate the to-
tal, you would enter a formula in cell B5. The formula would be B2 B3 B4.




Normal mathematical operations can be entered in a cell:
B2 B3 adds the contents of cells B2 and B3.
B2 B3 subtracts the contents of cell B3 from cell B2.
B2*B3 multiplies the contents of cell B2 by the contents of cell B3.
B2/B3 divides the contents of cell B2 by the contents of cell B3.
B2^B3 raises the number in cell B2 to the power of the number in cell B3.
F24 SECTION F1: The Accounting Information System
23
Accounting and Organizations

Copying Cell Contents
The contents (including a formula) can be copied from one cell or group of cells to an-
other cell or group of cells. To copy the contents, select the cells containing the data to
be copied and click on Edit/Copy. Then select the cell you want to copy to (or the up-
per, left cell of a group of cells) and click Edit/Paste.
The contents of a cell also can be copied to a neighboring cell using a shortcut pro-
cedure. In the following example, we want to copy the contents of cell B4 to cell C4.
Cell B4 contains the formula B2 B3. To copy the contents, we select cell B4 and drag
the cursor over the box in the lower, right corner of cell B4. The cursor changes shape
and appears as crosshairs ( ). If we click on the left mouse button while the cursor is
in this shape, we can drag the contents of cell B4 to cell C4. The formula B2 B3 is
copied to cell C4, except that the references are automatically adjusted for the new col-
umn, and the formula appears as C2 C3.




Box

When you enter a formula in a cell, such as B2 B3, the cell addresses are rela-
tive addresses. When the formula is copied to another cell, the relative addresses change.
Copying the contents of cell B4 above to cell C4 results in an adjustment in the for-
mula so that B2 B3 is changed to C2 C3. You can also enter absolute addresses.
An absolute address results from entering a dollar sign ($) before a cell address. For ex-
ample, if you enter $B2 $B3 in cell B4 and then copy cell B4 to cell C4, the formula
in C4 remains $B2 $B3. You can use absolute addresses for the column ( $B2), the
row ( B$2) or both ( $B$2).


Changing Column Widths
You can make a column wider or narrower using the Format/Column/Width menu. A
simpler approach is to move the cursor to the right-hand side of the column header of
the column you wish to adjust. The cursor changes to appear as . Click and drag
the cursor to the right or left to adjust the column width. The same procedure can be
used for row height adjustments.


Menus
The top of an Excel spreadsheet contains menus. A brief description of the menu items
you are likely to use on a regular basis follows.
File. Use the File menu to open a New spreadsheet, to Open an existing spreadsheet, to
Save a spreadsheet, to Print a spreadsheet, and to Close the Excel program.
Edit. Use the Edit menu to Delete a row, column, or cell. Select the row, column, or cell
and click Edit/Delete. You can delete the contents of a particular cell by selecting the cell
and pressing the Backspace or Delete key.
View. Use the View menu to select which Toolbars appear on the spreadsheet. The Header

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