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Preface from the eight edition:

Philosophy and purpose Imagine that you have graduated from college without taking an accounting course. You are

employed by a company as a sales person, and you eventually become the sales manager of a territory.

While attending a sales managers' meeting, financial results are reviewed by the Vice President of Sales

and terms such as gross margin percentage, cash flows from operating activities, and LIFO inventory

methods are being discussed. The Vice President eventually asks you to discuss these topics as they

relate to your territory. You try to do so, but it is obvious to everyone in the meeting that you do not

know what you are talking about.

Accounting principles courses teach you the "language of business" so you understand terms and

concepts used in business decisions. If you understand how accounting information is prepared, you

will be in an even stronger position when faced with a management decision based on accounting

information.

The importance of transactions analysis and proper recording of transactions has clearly been

demonstrated in some of the recent business failures that have been reported in the press. If the

financial statements of an enterprise are to properly represent the results of operations and the

financial condition of the company, the transactions must be analyzed and recorded in the accounts

following generally accepted accounting principles. The debits and credits are important not only to

accounting majors but also to those entering or engaged in a business career to become managers

because the ultimate effects of these journal entries are reflected in the financial statements. If

expenses are reported as assets, liabilities and their related expenses are omitted from the financial

statements, or reported revenues are recorded prematurely or do not really exist, the financial

statements are misleading. The financial statements are only useful and meaningful if they are fair and

clearly represent the business events of the company.

We wrote this text to give you an understanding of how to use accounting information to analyze

business performance and make business decisions. The text takes a business perspective. We use the

annual reports of real companies to illustrate many of the accounting concepts. You are familiar with

many of the companies we use, such as The Limited, The Home Depot, and Coca-Cola Company.

Gaining an understanding of accounting terminology and concepts, however, is not enough to

ensure your success. You also need to be able to find information on the Internet, analyze various

p. 4 of 433

business situations, work effectively as a member of a team, and communicate your ideas clearly. This

text was developed to help you develop these skills.

Curriculum concerns Significant changes have been recommended for accounting education. Some parties have

expressed concern that recent accounting graduates do not possess the necessary set of skills to

succeed in an accounting career. The typical accounting graduate seems unable to successfully deal

with complex and unstructured "real world" accounting problems and generally lacks communication

and interpersonal skills. One recommendation is the greater use of active learning techniques in a re-

energized classroom environment. The traditional lecture and structured problem solving method

approach would be supplemented or replaced with a more informal classroom setting dealing with

cases, simulations, and group projects. Both inside and outside the classroom, there would be two-way

communication between (1) professor and student and (2) student and student. Study groups would be

formed so that students could tutor other students. The purposes of these recommendations include

enhancing students' critical thinking skills, written and oral communication skills, and interpersonal

skills.

One of the most important benefits you can obtain from a college education is that you "learn how

to learn". The concept that you gain all of your learning in school and then spend the rest of your life

applying that knowledge is not valid. Change is occurring at an increasingly rapid pace. You will

probably hold many different jobs during your career, and you will probably work for many different

companies. Much of the information you learn in college will be obsolete in just a few years. Therefore,

you will be expected to engage in life-long learning. Memorizing is much less important than learning

how to think critically.

With this changing environment in mind, we have developed a text that will lend itself to developing

the skills that will lead to success in your future career in business. The section at the end of each

chapter titled, "Beyond the numbers—Critical thinking", provides the opportunity for you to address

unstructured case situations, the analysis of real companies' financial situations, ethics cases, and team

projects. Each chapter also includes one or two Internet projects in the section titled "Using the

Internet—A view of the real world". For many of these items, you will use written and oral

communication skills in presenting your results.

p. 5 of 433

Objectives and overall approach of the eighth edition

The Accounting Education Change Commission (AECC) made specific recommendations regarding

teaching materials and methods used in the first-year accounting course. As a result, significant

changes have taken place in that course at many universities. The AECC states:

The first course in accounting can significantly benefit those who enter business,

government, and other organizations, where decision-makers use accounting

information. These individuals will be better prepared for their responsibilities if they

understand the role of accounting information in decision-making by managers,

investors, government regulators, and others. All organizations have accountability

responsibilities to their constituents, and accounting, properly used, is a powerful tool in

creating information to improve the decisions that affect those constituents.1

One of the purposes of the first course should be to recruit accounting majors. To help accomplish

this, the text has a section preceding each chapter entitled, "Careers in accounting".

We retained a solid coverage of accounting that serves business students well regardless of the

majors they select. Those who choose not to major in accounting, which is a majority of those taking

this course, will become better users of accounting information because they will know something

about the preparation of that information.

Approach and organization

Business emphasis Without actual business experience, business students sometimes lack a frame of reference in

attempting to apply accounting concepts to business transactions. We seek to involve the business

student more in real world business applications as we introduce and explain the subject matter.

 "An accounting perspective: Business insight" boxes throughout the text provide

examples of how companies featured in text examples use accounting information every day, or

they provide other useful information.

1 Accounting Education Change Commission, Position Statement No. Two, “The First Course in

Account” (Torrance, CA, June 1992), pp. 1-2.

p. 6 of 433

 "Accounting perspective: Uses of technology" boxes throughout the text demonstrate

how technology has affected the way accounting information is prepared, manipulated, and

accessed.

 Some chapters contain "A broader perspective". These situations, taken from annual reports

of real companies and from articles in current business periodicals such as Accounting Today, and

Management Accounting, relate to subject matter discussed in that chapter or present other

useful information. These real world examples demonstrate the business relevance of accounting.

 Real world questions and real world business decision cases are included in almost every

chapter.

 The annual report appendix included with this text contains significant portions of the annual

report of The Limited, Inc. Many of the real world questions and business decision cases are based

on this annual report.

 Numerous illustrations adapted from Accounting Trends & Techniques show the frequency of

use in business of various accounting techniques. Placed throughout the text, these illustrations

give students real world data to consider while learning about different accounting techniques.

 Throughout the text we have included numerous references to the annual reports of many

companies.

 Chapters 1-16 contain a section entitled, "Analyzing and using the financial results". This section

discusses and illustrates a ratio or other analysis technique that pertains to the content of the

chapter. For instance, this section in Chapter 4 discusses the current ratio as it relates to a

classified balance sheet.

 Some of the chapters contain end-of-chapter questions, exercises, or business decision cases that

require the student to refer to the Annual report appendix and answer certain questions. As stated

earlier, this appendix is included with the text and contains the significant portions of the annual

report of The Limited, Inc.

 Each chapter contains a section entitled, "Beyond the numbers—Critical thinking". This section

contains business decision cases, annual report analysis problems, writing assignments based on

the Ethical perspective and Broader perspective boxes, group projects, and Internet projects.

p. 7 of 433

Pedagogy Students often come into accounting principles courses feeling anxious about learning the subject

matter. Recognizing this apprehension, we studied ways to make learning easier and came up with

some helpful ideas on how to make this edition work even better for students.

 Improvements in the text's content reflect feedback from adopters, suggestions by reviewers,

and a serious study of the learning process itself by the authors and editors. New subject matter is

introduced only after the stage has been set by transitional paragraphs between topic headings.

These paragraphs provide students with the reasons for proceeding to the new material and

explain the progression of topics within the chapter.

 The Introduction contains a section entitled "How to study the chapters in this text", which

should be very helpful to students.

 Each chapter has an "Understanding the learning objectives" section. These "summaries" enable

the student to determine how well the learning objectives were accomplished. We were the first

authors (1974) to ever include Learning objectives in an accounting text. These objectives have

been included at the beginning of the chapter, as marginal notes within the chapter, at the end of

the chapter, and in supplements such as the Test bank, Instructors' resource guide, Computerized

test bank, and Study guide. The objectives are also indicated for each exercise and problem.

 Demonstration problems and solutions are included for each chapter, and a different one

appears for each chapter in the Study guide. These demonstration problems help students to

assess their own progress by showing them how problems that focus on the topic(s) covered in the

chapter are worked before students do assigned homework problems.

 Key terms are printed for emphasis. End-of-chapter glossaries contain the definition.

 Each chapter includes a "Self-test" consisting of true-false and multiple-choice questions. The

answers and explanations appear at the end of the chapter. These self-tests are designed to

determine whether the student has learned the essential information in each chapter.

 In the margin beside each exercise and problem, we have included a description of the

requirements and the related Learning objective(s). These descriptions let students know what

they are expected to do in the problem.

 Throughout the text we use examples taken from everyday life to relate an accounting concept

being introduced or discussed to students' experiences.

p. 8 of 433

Ethics There is no better time to emphasize high ethical standards to students. This text includes many

items throughout the text entitled, "An ethical perspective". These items present situations in which

students are likely to find themselves throughout their careers. They range from resisting pressure by a

superior or a client to do the wrong thing to deciding between alternative corporate behaviors that have

environmental and profit consequences.

End-of-chapter materials Describing teaching methods, the AECC stated, "Teachers...should place a priority on their

interaction with students and on interaction among students. Students' involvement should be

promoted by methods such as cases, simulations, and group projects..."2 A section entitled "Beyond the

numbers—Critical thinking" at the end of every chapter is designed to implement these

recommendations. Business decision cases require critical thinking in complex situations often based

on real companies. The Annual report analysis section requires analyzing annual reports and

interpreting the results in writing. The Ethics cases require students to respond in writing to situations

they are likely to encounter in their careers. These cases do not necessarily have one right answer. The

Group projects for each chapter teach students how to work effectively in teams, a skill that was

stressed by the AECC and is becoming increasingly necessary for success in business. The Internet

projects teach students how to retrieve useful information from the Internet.

A team approach can also be introduced in the classroom using the regular exercises and problems

in the text. Teams can be assigned the task of presenting their solutions to exercises or problems to the

rest of the class. Using this team approach in class can help re-energize the classroom by creating an

active, informal environment in which students learn from each other. (Two additional group projects

are described in the Instructor's resource guide. These projects are designed to be used throughout the

semester or quarter.)

We have included a vast amount of other resource materials for each chapter within the text from

which the instructor may draw: (1) one of the largest selections of end-of-chapter questions, exercises,

and problems available; (2) several comprehensive review problems that allow students to review all

major concepts covered to that point; and (3) from one to three business decision cases per chapter.

Other key features regarding end-of-chapter material follow.

2Ibid, p.2.

p. 9 of 433

 A uniform chart of accounts appears in a separate file you can download. This uniform chart of

accounts is used consistently throughout the first 11 chapters. We believe students will benefit

from using the same chart of accounts for all homework problems in those chapters.

 A comprehensive review problem at the end of Chapter 4 serves as a mini practice set to test all

material covered to that point. Another comprehensive problem at the end of Chapter 19 reviews

the material covered in Chapters 18 and 19. Two comprehensive budgeting problems are also

included as business decision cases at the end of Chapter 23.

 Some of the end-of-chapter problem materials (questions, exercises, problems, business decision

cases, other "Beyond the numbers" items, and comprehensive review problems) have been

updated. Each exercise and problem is identified with the learning objective(s) to which it relates.

 All end-of-chapter exercises and problems have been traced back to the chapters to ensure that

nothing is asked of a student that does not appear in the book. This feature was a strength of

previous editions, ensuring that instructors could confidently assign problems without having to

check for applicability. Also, we took notes while teaching from the text and clarified problem and

exercise instructions that seemed confusing to our students.

p. 10 of 433

Table of Contents

1 The Accounting Environment...........................................................................................14

1.1 Learning objectives.........................................................................................................14 1.2 Accounting Defined........................................................................................................15 1.3 Employment opportunities in accounting......................................................................17 1.4 Financial accounting versus managerial accounting......................................................21 1.5 Development of financial accounting standards............................................................23 1.6 Ethical behavior of accountants.....................................................................................25 1.7 Critical thinking and communication skills...................................................................26 1.8 Internet skills..................................................................................................................27 1.9 How to study the chapters in this text............................................................................27

2 Accounting and its use in business decisions...................................................................30

2.1 Learning objectives........................................................................................................30 2.2 A career as an entrepreneur..........................................................................................30 2.3 Forms of business organizations....................................................................................31 2.4 Types of activities performed by business organizations..............................................33 2.5 Financial statements of business organizations............................................................34 2.6 The financial accounting process...................................................................................39 2.7 Underlying assumptions or concepts ...........................................................................40 2.8 Transactions affecting only the balance sheet ..............................................................41 2.9 Transactions affecting the income statement and/or balance sheet ............................45 2.10 Summary of balance sheet and income statement transactions.................................48 2.11 Dividends paid to owners (stockholders).....................................................................49 2.12 Analyzing and using the financial results—the equity ratio.........................................52 2.13 Understanding the learning objectives........................................................................53 2.14 Appendix: A comparison of corporate accounting with accounting for a sole proprietorship and a partnership.........................................................................................54 2.15 Demonstration problem...............................................................................................55 2.16 Solution to demonstration problem.............................................................................57 2.17 Key terms......................................................................................................................58 2.18 Self-test........................................................................................................................60

3 Recording business transactions.......................................................................................77

3.1 Learning objectives.........................................................................................................77 3.2 Salary potential of accountants......................................................................................77 3.3 The account and rules of debit and credit......................................................................79 3.4 Recording changes in assets, liabilities, and stockholders' equity.................................81

p. 11 of 433

3.5 The accounting cycle......................................................................................................86 3.6 The journal.....................................................................................................................87 3.7 The ledger......................................................................................................................90 3.8 The accounting process in operation.............................................................................91 3.9 The use of ledger accounts...........................................................................................105 3.10 Analyzing and using the financial results— Horizontal and vertical analyses...........115 3.11 Key terms.....................................................................................................................123 3.12 Self-test.......................................................................................................................124

4 Adjustments for financial reporting................................................................................144

4.1 Learning objectives.......................................................................................................144 4.2 A career as a tax specialist............................................................................................144 4.3 Cash versus accrual basis accounting...........................................................................145 4.4 The need for adjusting entries......................................................................................147 4.5 Classes and types of adjusting entries..........................................................................149 4.6 Adjustments for deferred items....................................................................................151 4.7 Adjustments for accrued items.....................................................................................162 4.8 Effects of failing to prepare adjusting entries..............................................................166 4.9 Analyzing and using the financial results—trend percentages....................................166 4.10 Understanding the learning objectives.......................................................................167

5 Completing the accounting cycle....................................................................................190

5.1 Learning objectives.......................................................................................................190 5.2 A career in information systems..................................................................................190 5.3 The accounting cycle summarized................................................................................191 5.4 The work sheet..............................................................................................................191 5.5 Preparing financial statements from the work sheet...................................................199 5.6 Journalizing adjusting entries.....................................................................................200 5.7 The closing process.......................................................................................................201 5.8 Accounting systems: From manual to computerized..................................................210 5.9 A classified balance sheet.............................................................................................216 5.10 Analyzing and using the financial results — the current ratio...................................223 5.11 Understanding the learning objectives.......................................................................224

6 Accounting theory...........................................................................................................254

6.1 Learning objectives......................................................................................................254 6.2 A career as an accounting professor............................................................................254 6.3 Traditional accounting theory.....................................................................................255 6.4 Underlying assumptions or concepts..........................................................................256 6.5 Other basic concepts....................................................................................................258 6.6 The measurement process in accounting....................................................................259 6.7 The major principles....................................................................................................260 6.8 Modifying conventions (or constraints)......................................................................268 6.9 The financial accounting standards board's conceptual framework project...............270

p. 12 of 433

6.10 Objectives of financial reporting................................................................................271 6.11 Qualitative characteristics..........................................................................................273 6.12 The basic elements of financial statements................................................................277 6.13 Recognition and measurement in financial statements.............................................279 6.14 Summary of significant accounting policies..............................................................279 6.15 Significant accounting policies..................................................................................280 6.16 Understanding the learning objectives......................................................................283

7 Introduction to inventories and the classified income statement..................................303

7.1 Learning objective .......................................................................................................303 7.2 A career as a CEO.........................................................................................................303 7.3 Two income statements compared— Service company and merchandising company ............................................................................................................................................305 7.4 Sales revenues..............................................................................................................305 7.5 Cost of goods sold.........................................................................................................313 7.6 Classified income statement........................................................................................324 7.7 Analyzing and using the financial results—Gross margin percentage.........................329 7.8 Understanding the learning objectives........................................................................329 7.9 Appendix: The work sheet for a merchandising company...........................................331 7.10 Key terms...................................................................................................................338 7.11 Self-test.......................................................................................................................340

8 Measuring and reporting inventories.............................................................................359

8.1 Learning objectives......................................................................................................359 8.2 Choosing an accounting career....................................................................................359 8.3 Inventories and cost of goods sold..............................................................................360 8.4 Importance of proper inventory valuation..................................................................361 8.5 Determining inventory cost.........................................................................................363 8.6 Departures from cost basis of inventory measurement..............................................387 8.7 Analyzing and using financial results—inventory turnover ratio................................395 8.8 Understanding the learning objectives........................................................................395

Alphabetical Index..............................................................................................................427

p. 13 of 433

1 The Accounting Environment

1.1 Learning objectives

After studying this introduction, you should be able to:

 Define accounting.

 Describe the functions performed by accountants.

 Describe employment opportunities in accounting.

 Differentiate between financial and managerial accounting.

 Identify several organizations that have a role in the development of financial accounting

standards.

You have embarked on the challenging and rewarding study of accounting—an old and time-

honored discipline. History indicates that all developed societies require certain accounting records.

Record-keeping in an accounting sense is thought to have begun about 4000 BCE

The record-keeping, control, and verification problems of the ancient world had many

characteristics similar to those we encounter today. For example, ancient governments also kept

records of receipts and disbursements and used procedures to check on the honesty and reliability of

employees.

A study of the evolution of accounting suggests that accounting processes have developed primarily

in response to business needs. Also, economic progress has affected the development of accounting

processes. History shows that the higher the level of civilization, the more elaborate the accounting

methods.

The emergence of double-entry bookkeeping was a crucial event in accounting history. In 1494, a

Franciscan monk, Luca Pacioli, described the double-entry Method of Venice system in his text called

Summa de Arithmetica, Geometric, Proportion et Proportionate (Everything about arithmetic,

geometry, and proportion). Many consider Pacioli's Summa to be a reworked version of a manuscript

that circulated among teachers and pupils of the Venetian school of commerce and arithmetic.

Since Pacioli's days, the roles of accountants and professional accounting organizations have

expanded in business and society. As professionals, accountants have a responsibility for placing public

service above their commitment to personal economic gain. Complementing their obligation to society,

accountants have analytical and evaluative skills needed in the solution of ever-growing world

p. 14 of 433

problems. The special abilities of accountants, their independence, and their high ethical standards

permit them to make significant and unique contributions to business and areas of public interest.

You probably will find that of all the business knowledge you have acquired or will learn, the study

of accounting will be the most useful. Your financial and economic decisions as a student and

consumer involve accounting information. When you file income tax returns, accounting information

helps determine your taxes payable. Understanding the discipline of accounting also can influence

many of your future professional decisions. You cannot escape the effects of accounting information on

your personal and professional life.

Every profit-seeking business organization that has economic resources, such as money, machinery,

and buildings, uses accounting information. For this reason, accounting is called the language of

business. Accounting also serves as the language providing financial information about not-for-profit

organizations such as governments, churches, charities, fraternities, and hospitals. However, this text

concentrates on accounting for business firms.

The accounting system of a profit-seeking business is an information system designed to provide

relevant financial information on the resources of a business and the effects of their use. Information is

relevant if it has some impact on a decision that must be made. Companies present this relevant

information in their financial statements. In preparing these statements, accountants consider the

users of the information, such as owners and creditors, and decisions they make that require financial

information.

As a background for studying accounting, this Introduction defines accounting and lists the

functions accountants perform. In addition to surveying employment opportunities in accounting, it

differentiates between financial and managerial accounting. Because accounting information must

conform to certain standards, we discuss several prominent organizations contributing to these

standards. As you continue your study of accounting in this text, accounting—the language of business

—will become your language also. You will realize that you are constantly exposed to accounting

information in your everyday life.

1.2 Accounting Defined

The American Accounting Association—one of the accounting organizations discussed later in this

Introduction—defines accounting as "the process of identifying, measuring, and communicating

p. 15 of 433

economic information to permit informed judgments and decisions by the users of the information".1

This information is primarily financial—stated in money terms. Accounting, then, is a measurement

and communication process used to report on the activities of profit-seeking business organizations

and not-for-profit organizations. As a measurement and communication process for business,

accounting supplies information that permits informed judgments and decisions by users of the data.

The accounting process provides financial data for a broad range of individuals whose objectives in

studying the data vary widely. Bank officials, for example, may study a company's financial statements

to evaluate the company's ability to repay a loan. Prospective investors may compare accounting data

from several companies to decide which company represents the best investment. Accounting also

supplies management with significant financial data useful for decision making.

Reliable information is necessary before decision makers can make a sound decision involving the

allocation of scarce resources. Accounting information is valuable because decision makers can use it

to evaluate the financial consequences of various alternatives. Accountants eliminate the need for a

crystal ball to estimate the future. They can reduce uncertainty by using professional judgment to

quantify the future financial impact of taking action or delaying action.

Although accounting information plays a significant role in reducing uncertainty within the

organization, it also provides financial data for persons outside the company. This information tells

how management has discharged its responsibility for protecting and managing the company's

resources. Stockholders have the right to know how a company is managing its investments. In

fulfilling this obligation, accountants prepare financial statements such as an income statement, a

statement of retained earnings, a balance sheet, and a statement of cash flows. In addition, they

prepare tax returns for federal and state governments, as well as fulfill other governmental filing

requirements.

Accounting is often confused with bookkeeping. Bookkeeping is a mechanical process that records

the routine economic activities of a business. Accounting includes bookkeeping but goes well beyond it

in scope. Accountants analyze and interpret financial information, prepare financial statements,

conduct audits, design accounting systems, prepare special business and financial studies, prepare

forecasts and budgets, and provide tax services.

Specifically the accounting process consists of the following groups of functions (see Exhibit 1

below):

1 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, III.,

1966), p. 1.

p. 16 of 433

 Accountants observe many events (or activities) and identify and measure in financial terms

(dollars) those events considered evidence of economic activity. (Often, these three functions are

collectively referred to as analyze.) The purchase and sale of goods and services are economic

events.

 Next, the economic events are recorded, classified into meaningful groups, and summarized.

 Accountants report on economic events (or business activity) by preparing financial statements

and special reports. Often accountants interpret these statements and reports for various groups

such as management, investors, and creditors. Interpretation may involve determining how the

business is performing compared to prior years and other similar businesses.

1.3 Employment opportunities in accounting

During the last half-century, accounting has gained the same professional status as the medical and

legal professions. Today, the accountants in the United States number well over a million. In addition,

several million people hold accounting-related positions. Typically, accountants provide services in

various branches of accounting. These include public accounting, management (industrial) accounting,

governmental or other not-for-profit accounting, and higher education. The demand for accountants

will likely increase dramatically in the future. This increase is greater than for any other profession.

You may want to consider accounting as a career.

Public accounting firms offer professional accounting and related services for a fee to

companies, other organizations, and individuals. An accountant may become a Certified Public

Accountant (CPA) by passing an examination prepared and graded by the American Institute of

Certified Public Accountants (AICPA). The exam is administered by computer. In addition to passing

the exam, CPA candidates must meet other requirements, which include obtaining a state license.

These requirements vary by state. A number of states require a CPA candidate to have completed

specific accounting courses and earned a certain number of college credits (five years of study in many

states); worked a certain number of years in public accounting, industry, or government; and lived in

that state a certain length of time before taking the CPA examination. As of the year 2000, five years of

course work were required to become a member of the AICPA.

After a candidate passes the CPA examination, some states (called one-tier states) insist that the

candidate meet all requirements before the state grants the CPA certificate and license to practice.

Other states (called two-tier states) issue the CPA certificate immediately after the candidate passes the

exam. However, these states issue the license to practice only after all other requirements have been

met. CPAs who want to renew their licenses to practice must stay current through continuing

p. 17 of 433

professional education programs and must prove that they have done so. No one can claim to be a CPA

and offer the services normally provided by a CPA unless that person holds an active license to

practice.

p. 18 of 433

Exhibit 1: Functions performed by accountants

The public accounting profession in the United States consists of the Big-Four international CPA

firms, several national firms, many regional firms, and numerous local firms. The Big-Four firms

include Deloitte & Touche, Ernst & Young, KPMG, and Pricewaterhouse Coopers. At all levels, these

public accounting firms provide auditing, tax, and, for nonaudit clients, management advisory (or

consulting) services.

Auditing A business seeking a loan or attempting to have its securities traded on a stock exchange

usually must provide financial statements to support its request. Users of a company's financial

statements are more confident that the company is presenting its statements fairly when a CPA has

audited the statements. For this reason, companies hire CPA firms to conduct examinations

(independent audits) of their accounting and related records. Independent auditors of the CPA

firm check some of the company's records by contacting external sources. For example, the accountant

may contact a bank to verify the cash balances of the client. After completing a company audit,

independent auditors give an independent auditor's opinion or report. (For an example of an

auditor's opinion, see The Limited, Inc. annual report in the Annual report appendix at the end of the

text.) This report states whether the company's financial statements fairly (equitably) report the

economic performance and financial condition of the business. As you will learn in the next section,

auditors within a business also conduct audits, which are not independent audits. Currently auditing

standards are established by the Public Company Accounting Oversight Board.

In 2002 The Sarbanes-Oxley Act was passed. The Act was passed as one result of the large losses to

the employees and investors from accounting fraud situations involving companies such as Enron and

WorldCom. The Act created the Public Company Accounting Oversight Board. The Board consists of

five members appointed and overseen by the Securities and Exchange Commission. The Board

oversees and investigates the audits and auditors of public companies and can sanction both firms and

individuals for violations of laws, regulations, and rules. The Chief Executive Officer and Chief

Financial Officer of a public company must now certify the company's financial statements. Corporate

audit committees, rather than the corporate management, are now responsible for hiring,

compensating, and overseeing the external auditors.

Tax services CPAs often provide expert advice on tax planning and preparing federal, state, and

local tax returns. The objective in preparing tax returns is to use legal means to minimize the taxes

paid. Almost every major business decision has a tax impact. Tax planning helps clients know the tax

effects of each financial decision.

Management advisory (or consulting) services Before Sarbanes-Oxley management advisory

services were the fastest growing service area for most large and many smaller CPA firms. Management

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frequently identifies projects for which it decides to retain the services of a CPA. However, the

Sarbanes-Oxley Act specifically prohibits providing certain types of consulting services to a publicly-

held company by its external auditor. These services include bookkeeping, information systems design

and implementation, appraisals or valuation services, actuarial services, internal audits, management

and human resources services, broker/dealer and investment services, and legal or expert services

related to audit services. Accounting firms can perform many of these services for publicly held

companies they do not audit. Other services not specifically banned are allowed if pre-approved by the

company's audit committee.

In contrast to public accountants, who provide accounting services for many clients, management

accountants provide accounting services for a single business. In a company with several management

accountants, the person in charge of the accounting activity is often the controller or chief financial

officer.

Management accountants may or may not be CPAs. If management accountants pass an

examination prepared and graded by the Institute of Certified Management Accountants (ICMA) and

meet certain other requirements, they become Certified Management Accountants (CMAs). The

ICMA is an affiliate of the Institute of Management Accountants, an organization primarily consisting

of management accountants employed in private industry.

A career in management accounting can be very challenging and rewarding. Many management

accountants specialize in one particular area of accounting. For example, some may specialize in

measuring and controlling costs, others in budgeting (the development of plans for future operations),

and still others in financial accounting and reporting. Many management accountants become

specialists in the design and installation of computerized accounting systems. Other management

accountants are internal auditors who conduct internal audits. They ensure that the company's

divisions and departments follow the policies and procedures of management. This last group of

management accountants may earn the designation of Certified Internal Auditor (CIA). The

Institute of Internal Auditors (IIA) grants the CIA certificate to accountants after they have successfully

completed the IIA examination and met certain other requirements.

Many accountants, including CPAs, work in governmental and other not-for-profit

accounting. They have essentially the same educational background and training as accountants in

public accounting and management accounting.

Governmental agencies at the federal, state, and local levels employ governmental accountants.

Often the duties of these accountants relate to tax revenues and expenditures. For example, Internal

Revenue Service employees use their accounting backgrounds in reviewing tax returns and

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investigating tax fraud. Government agencies that regulate business activity, such as a state public

service commission that regulates public utilities (e.g. telephone company, electric company), usually

employ governmental accountants. These agencies often employ governmental accountants who can

review and evaluate the utilities' financial statements and rate increase requests. Also, FBI agents

trained as accountants find their accounting backgrounds useful in investigating criminals involved in

illegal business activities, such as drugs or gambling.

Not-for-profit organizations, such as churches, charities, fraternities, and universities, need

accountants to record and account for funds received and disbursed. Even though these agencies do

not have a profit motive, they should operate efficiently and use resources effectively.

Approximately 10,000 accountants are employed in higher education. The activities of these

academic accountants include teaching accounting courses, conducting scholarly and applied

research and publishing the results, and performing service for the institution and the community.

Faculty positions exist in two-year colleges, four-year colleges, and universities with graduate

programs. A significant shortage of accounting faculty has developed due to the retirement beginning

in the late 1990s of many faculty members. Starting salaries will continue to rise significantly because

of the shortage. You may want to talk with some of your professors about the advantages and

disadvantages of pursuing an accounting career in higher education.

A section preceding each chapter, entitled "Careers in accounting", describes various accounting

careers. You might find one that you would like to pursue.

1.4 Financial accounting versus managerial accounting

An accounting information system provides data to help decision makers both outside and inside

the business. Decision makers outside the business are affected in some way by the performance of the

business. Decision makers inside the business are responsible for the performance of the business. For

this reason, accounting is divided into two categories: financial accounting for those outside and

managerial accounting for those inside.

Financial accounting information appears in financial statements that are intended primarily for

external use (although management also uses them for certain internal decisions). Stockholders and

creditors are two of the outside parties who need financial accounting information. These outside

parties decide on matters pertaining to the entire company, such as whether to increase or decrease

their investment in a company or to extend credit to a company. Consequently, financial accounting

information relates to the company as a whole, while managerial accounting focuses on the parts or

segments of the company.

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Management accountants in a company prepare the financial statements. Thus, management

accountants must be knowledgeable concerning financial accounting and reporting. The financial

statements are the representations of management, not the CPA firm that performs the audit.

The external users of accounting information fall into six groups; each has different interests in the

company and wants answers to unique questions. The groups and some of their possible questions are:

 Owners and prospective owners. Has the company earned satisfactory income on its total

investment? Should an investment be made in this company? Should the present investment be

increased, decreased, or retained at the same level? Can the company install costly pollution

control equipment and still be profitable?

 Creditors and lenders. Should a loan be granted to the company? Will the company be able

to pay its debts as they become due?

 Employees and their unions. Does the company have the ability to pay increased wages? Is

the company financially able to provide long-term employment for its workforce?

 Customers. Does the company offer useful products at fair prices? Will the company survive

long enough to honor its product warranties?

 Governmental units. Is the company, such as a local public utility, charging a fair rate for its

services?

 General public. Is the company providing useful products and gainful employment for citizens

without causing serious environmental problems?

General-purpose financial statements provide much of the information needed by external users of

financial accounting. These financial statements are formal reports providing information on a

company's financial position, cash inflows and outflows, and the results of operations. Many

companies publish these statements in annual reports. (See The Limited, Inc., annual report in the

Annual report appendix.) The annual report also contains the independent auditor's opinion as to

the fairness of the financial statements, as well as information about the company's activities, products,

and plans.

Financial accounting information is historical in nature, reporting on what has happened in the

past. To facilitate comparisons between companies, this information must conform to certain

accounting standards or principles called generally accepted accounting principles (GAAP).

These generally accepted accounting principles for businesses or governmental organizations have

developed through accounting practice or been established by an authoritative organization. We

describe several of these authoritative organizations in the next major section of this Introduction.

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Managerial accounting information is for internal use and provides special information for the

managers of a company. The information managers use may range from broad, long-range planning

data to detailed explanations of why actual costs varied from cost estimates. Managerial accounting

information should:

 Relate to the part of the company for which the manager is responsible. For example, a

production manager wants information on costs of production but not of advertising.

 Involve planning for the future. For instance, a budget would show financial plans for the

coming year.

 Meet two tests: the accounting information must be useful (relevant) and must not cost more to

gather and process than it is worth.

Managerial accounting generates information that managers can use to make sound decisions. The

four major types of internal management decisions are:

 Financial decisions—deciding what amounts of capital (funds) are needed to run the business

and whether to secure these funds from owners (stockholders) or creditors. In this sense, capital

means money used by the company to purchase resources such as machinery and buildings and to

pay expenses of conducting the business.

 Resource allocation decisions—deciding how the total capital of a company is to be

invested, such as the amount to be invested in machinery.

 Production decisions—deciding what products are to be produced, by what means, and

when.

 Marketing decisions—setting selling prices and advertising budgets; determining the location

of a company's markets and how to reach them.

1.5 Development of financial accounting standards

Several organizations are influential in the establishment of generally accepted accounting

principles (GAAP) for businesses or governmental organizations. These are the American Institute of

Certified Public Accountants, the Financial Accounting Standards Board, the Governmental

Accounting Standards Board, the Securities and Exchange Commission, the American Accounting

Association, the Financial Executives Institute, and the Institute of Management Accountants. Each

organization has contributed in a different way to the development of GAAP.

The American Institute of Certified Public Accountants (AICPA) is a professional organization of

CPAs. Many of these CPAs are in public accounting practice. Until recent years, the AICPA was the

dominant organization in the development of accounting standards. In a 20-year period ending in

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1959, the AICPA Committee on Accounting Procedure issued 51 Accounting Research Bulletins

recommending certain principles or practices. From 1959 through 1973, the committee's successor, the

Accounting Principles Board (APB), issued 31 numbered Opinions that CPAs generally are

required to follow. Through its monthly magazine, the Journal of Accountancy, its research division,

and its other divisions and committees, the AICPA continues to influence the development of

accounting standards and practices. Two of its committees—the Accounting Standards Committee and

the Auditing Standards Committee—are particularly influential in providing input to the Financial

Accounting Standards Board (the current rule-making body) and to the Securities and Exchange

Commission and other regulatory agencies.

In 1973, an independent, seven-member, full-time Financial Accounting Standards Board

(FASB) replaced the Accounting Principles Board. The FASB has issued numerous Statements of

Financial Accounting Standards. The old Accounting Research Bulletins and Accounting Principles

Board Opinions are still effective unless specifically superseded by a Financial Accounting Standards

Board Statement. The FASB is the private sector organization now responsible for the development of

new financial accounting standards.

The Emerging Issues Task Force of the FASB interprets official pronouncements for general

application by accounting practitioners. The conclusions of this task force must also be followed in

filings with the Securities and Exchange Commission.

In 1984, the Governmental Accounting Standards Board (GASB) was established with a

full-time chairperson and four part-time members. The GASB issues statements on accounting and

financial reporting in the governmental area. This organization is the private sector organization now

responsible for the development of new governmental accounting concepts and standards. The GASB

also has the authority to issue interpretations of these standards.

Created under the Securities and Exchange Act of 1934, the Securities and Exchange

Commission (SEC) is a government agency that administers important acts dealing with the

interstate sale of securities (stocks and bonds). The SEC has the authority to prescribe accounting and

reporting practices for companies under its jurisdiction. This includes virtually every major US

business corporation. Instead of exercising this power, the SEC has adopted a policy of working closely

with the accounting profession, especially the FASB, in the development of accounting standards. The

SEC indicates to the FASB the accounting topics it believes the FASB should address.

Consisting largely of accounting educators, the American Accounting Association (AAA) has

sought to encourage research and study at a theoretical level into the concepts, standards, and

principles of accounting. One of its quarterly magazines, The Accounting Review, carries many articles